Copyright 2009. All rights reserved.
The Financial Accounting Standards Board (FASB) issued SFAS 157, Fair Value Measurements, in September 2006 to define fair value, establish a framework for measuring fair value in generally accepted accounting principles (GAAP), and expand disclosures about fair value measurements. Fair value accounting standards, including SFAS 157, have come under scrutiny in light of the distressed housing market and economy. Opponents of fair value accounting argue that the use of fair value accounting, especially when markets are illiquid, has resulted in the valuing of assets well below their true economic value. Some opponents have even argued that SFAS 157 caused the recent financial institution failures. Proponents, on the other hand, argue that fair value accounting provides useful information to investors and its suspension would increase market uncertainty and decrease transparency.
The Emergency Economic Stabilization Act of 2008 (the Act) was signed into law on October 3, 2008 and included $700 billion in TARP funding. Approximately $350 billion of the TARP funds have been used to recapitalize financial institutions that use SFAS 157 to report asset values. In response to opponents of SFAS 157, the Act directed the SEC, together with the Board of Governors of the Federal Reserve System and the Secretary of the Treasury, to study mark-to-market accounting standards and SFAS 157 and gave the SEC authority to suspend use of SFAS 157, if deemed appropriate. The Act created a precedence of legislating the ability to suspend accounting standards set forth by the FASB, the entity responsible for establishing accounting standards.
On December 30, 2008, the SEC delivered its report to Congress recommending against the suspension of fair value accounting standards and concluding that SFAS 157 was not the cause of the recent bank failures. The SEC's report includes an overall analysis of fair value accounting including mark-to-market accounting and SFAS 157 as subsets of fair value accounting.
This article briefly summarizes SFAS 157 and the current positions of the FASB and SEC.
Summary of SFAS 157
SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. It is important to note, that SFAS 157 does not determine when fair value should be applied. The requirement of mark-to-market and fair value accounting has been in place for years and is set forth in other accounting standards, including but not limited to, SFAS 115, Accounting for Certain Investments in Debt and Equity Securities; SFAS 130, Reporting Other Comprehensive Income; SFAS 133, Accounting for Derivative Instruments and Hedging Activities; and SFAS 155, Accounting for Certain Hybrid Financial Instruments. Therefore, SFAS 157 is only one part of the broader context of fair value accounting.
Also, SFAS 157 does not require that fair value be applied to specific assets or liabilities; however, it does clarify how to determine fair value if an asset or liability is to be valued according to fair value criteria.
Fair Value Definition
The fair value of an asset or liability is defined in SFAS 157 as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." SFAS 157 provides additional guidance as follows:
Orderly Transaction: "An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction..."
Principal Market: "A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The principal market is the market in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity for the asset or liability."
Market Participants: "Market participants are buyers and sellers in the principal (or most advantageous) market for the asset or liability that are: Independent...Knowledgeable... Able to transact...Willing to transact."
Highest and Best Use: "A fair value measurement assumes the highest and best use of the asset by market participants, considering the use of the asset that is physically possible, legally permissible, and financially feasible at the measurement date."
SFAS 157 identifies three valuation techniques, summarized as follows:
Market Approach: "The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (including a business). For example, valuation techniques consistent with the market approach often use market multiples derived from a set of comparables."
Income Approach: "The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount (discounted). The measurement is based on the value indicated by current market expectations about those future amounts."
Cost Approach: "The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost)."
Fair Value Disclosures
SFAS 157 "establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from sources independent of the reporting entity (observable inputs) and (2) the reporting entity's own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The notion of unobservable inputs is intended to allow for situations in which there is little, if any, market activity for the asset or liability at the measurement date." SFAS 157 indicates that valuation techniques should maximize the use of observable inputs and minimize the use of unobservable inputs.
SFAS 157 sets forth a fair value hierarchy that categorizes the inputs to valuation techniques into three broad levels, summarized as follows:
Level 1: "Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. An active market for the asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis."
Level 2: "Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly." Examples of Level 2 inputs include the following: quoted prices for similar assets or liabilities in active markets or in markets that are not active and inputs other than quoted prices that are observable for the asset or liability.
Level 3: "Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs shall be used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date."
FASB and SEC Positions
On September 30, 2008, the SEC's Office of the Chief Accountant and the staff of the FASB issued a joint press release that provided clarifications on fair value accounting, including clarifications related to SFAS 157. Some of the clarifications set forth in the joint press release are summarized as follows:
"When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable....The determination of fair value often requires significant judgment."
"However, when markets are less active, brokers may rely more on models with inputs based on the information available only to the broker."
"The results of disorderly transactions are not determinative when measuring fair value."
"However, if prices in an inactive market do not reflect current prices for the same or similar assets, adjustments may be necessary to arrive at fair value. A significant increase in the spread between the amount sellers are ‘asking' and the price that buyers are ‘bidding,' or the presence of a relatively small number of ‘bidding' parties, are indicators that should be considered in determining whether a market is inactive."
"In general, the greater the decline in value, the greater the period of time until anticipated recovery, and the longer the period of time that a decline has existed, the greater the level of evidence necessary to reach a conclusion that an other-than-temporary decline has not occurred....Existing U.S. GAAP does not provide ‘bright lines' or ‘safe harbors' in making a judgment about other-than-temporary impairments. However, ‘rules of thumb' that consider the nature of the underlying investment can be useful tools for management and auditors in identifying securities that warrant a higher level of evaluation."
On October 10, 2008, the FASB issued FASB Staff Position 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active (FSP FAS 157-3). FSP FAS 157-3 clarifies the application of SFAS 157 in a market that is not active. FSP FAS 157-3 provides additional guidance summarized, in part, as follows:
"Determining fair value in a dislocated market depends on the facts and circumstances and may require the use of significant judgment about whether individual transactions are forced liquidations or distressed sales."
"In determining fair value for a financial asset, the use of a reporting entity's own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not available....Regardless of the valuation technique used, an entity must include appropriate risk adjustments that market participants would make for nonperformance and liquidity risks."
"In an active market, a broker quote should reflect market information from actual transactions. However, when markets are not active, brokers may rely more on models with inputs based on information available only to the broker."
SEC's Current Position
On December 30, 2008, the SEC delivered its report to Congress recommending against the suspension of fair value accounting standards, particularly SFAS 157. The report makes eight recommendations to improve the application of fair value accounting standards, summarized as follows:
- SFAS 157 should be improved, but not suspended.
- Existing fair value and mark-to-market requirements should not be suspended.
- Additional measures should be taken to improve the application and practice related to existing fair value requirements (especially as they relate to both Level 2 and Level 3 estimates).
- The accounting for financial asset impairments should be readdressed.
- Implement further guidance to foster the use of sound judgment.
- Accounting standards should continue to be established to meet the needs of investors.
- Additional formal measures to address the operation of existing accounting standards in practice should be established.
- Address the need to simplify the accounting for investments in financial assets.
Further, the SEC report concludes that fair value accounting did not appear to play a "meaningful role" in the bank failures that occurred in 2008. Instead, bank failures in the U.S. "appeared to be the result of growing probable credit losses, concerns about asset quality, and, in certain cases, eroding lender and investor confidence."
The SEC report states that most investors and other users of financial information who provided input to the SEC indicated that fair value accounting "transparently reflects, under current economic conditions, the value of assets and liabilities of the companies in which they invest. Most indicate that suspending fair value accounting would result in a loss of information and investor confidence."
For now, fair value accounting will continue to be required including SFAS 157 which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. It is important to search other accounting standards to determine when fair value accounting is required.
Finally, the SEC has concluded that SFAS 157 should not be suspended, but improvements to fair value accounting are recommended. The SEC also concluded that SFAS 157 was not the cause of the financial institution failures.
The articles on our Website include some of the publications and papers authored by our attorneys, both before and after they joined our firm. The content of these articles should not be taken as legal advice.